Analysis: Biotech craze vs. Net-mania

CBS.MarketWatch.com

SAN FRANCISCO (CBS.MW) -- It was late in Day Two of Hambrecht & Quist's week-long biotechnology conference, and they poured into the conference room to hear the presentation, acting almost like giddy girls rushing the stage at a Backstreet Boys concert.

"They don't have diddly squat. They have an idea."

Toni Gray, Biokeys Pharmaceuticals

Those lucky enough to get inside all huddled together, Armani suit pressed against Armani suit, in distances better suited to a rush-hour subway than a business meeting.

Room to sit? Heck, there was barely room to breathe.

So just what justified this sort of reaction from a couple of hundred hard-nosed, biotech-focused analysts, portfolio managers, venture capitalists, executives, and reporters. A new form of heart surgery? A cure for the common cold?

Try a Web site.

That's right. The company was none other than drugstore.com, the new e-tailing venture backed by Kleiner Perkins Caufield & Byers, the same VC firm that brought Amazon.com (AMZN)
AMZN, +2.01%
to Wall Street.

"I haven't seen this kind of excitement at this conference in several years," declared Samuel Colella, managing director at Palo Alto-based Institutional Venture Partners.

Some people thought the suit-clad throng was clueless to get excited about drugstore.com. "They don't have diddly squat. They have an idea," said Toni Gray, executive vice president of Los Angeles-based Biokeys Pharmaceuticals. "Meanwhile, we already have a company with $85 million in sales."

A little misty-eyed nostalgia

Yet if any industry should know how an idea alone can sometimes be enough, it's biotech. After all, these people haven't seen anything like the buzz being generated by the Internet since, well, the glory days of the early 1990s biotech boom.

Colella said he believed many people attended the drugstore.com presentation out of curiosity. But perhaps nostalgia also played a part.

OK, sure. Even at its height, the biotech craze never got as bubble-licious as Net mania has become. (If stocks could scoff, theglobe.com (TGLO)
TGLO, -12.67%
would surely do just that upon hearing of Genentech's (GNE)
GNE, -1.89%
104 percent first-day gain back in 1980.)

"We had a little mania" in biotech, said David Leathers, a venture capitalist with London-based Abingworth Management. "[The Internet] is a major mania. It's the mania of a lifetime."

But in some ways, Wall Street's latest infatuation with The Web-sters does mirror what happened in the biotech sector. Soaring stock prices based on promise, not profit. A genuine feeling that these small companies could change the world. Lots of hot IPOs. An endless supply of capital to go around for anybody with, yes, just an idea.

The fear, of course, is that the Internet craze will end in much the same way the biotech bubble burst -- with some major success stories, but mostly with a lot of broken dreams and empty wallets.

Blind optimism

"Anytime there's something that's new and outside the norm ... the mind begins to work on all the possible outcomes, often leading to an optimism that's blind to the level of risk," said Harlan Sonderling, portfolio manager of Evergreen Investment Management.

But is it fair to compare the Internet to biotech? Biotechnology as a science has fulfilled a lot of its promises, but many of the individual companies soon realized that their ideas were flawed, and thus their business models doomed. Biotech stocks were the ultimate concept story.

Internet companies, on the other hand, "have a much more concrete business model," said Wallace W. Wadman, partner at Boston, Mass.-based Constitution Research & Management.

Investors can at least compare the plans for most Internet companies to those of existing and profitable non-digital counterparts (Amazon.com to Barnes & Noble (BKS)
BKS, -2.00%
, CNET (CNET)
CNET, -0.73%
to Ziff-Davis (ZD)
zd
). And even the more speculative Internet companies (At Home (ATHM)
ATHM, -4.93%
, Broadcast.com (BCST)
bcst
) are generating healthy and fast-growing streams of revenue, something that couldn't be said for many small biotech stocks.

The U.S. government, as well, was a clear negative for the biotech industry, with a skeptical Food & Drug Administration keeping new drug approvals at a minimum for many years. (Only recently has the agency seen the light, approving a record 16 biotech-generated drugs last year).

By contrast, the government has pursued a surprisingly helpful hands-off policy towards the Internet. Aside from restrictions on exporting encryption-based security software, the government has so far let the industry handle its own problems, such as the domain name and privacy dilemmas. A moratorium on new Net taxes has been the biggest boost, allowing e-commerce to blossom.

Changing technologies

The industries have their similarities, however. Fortunes for several biotech companies waned because of new developments that made their research obsolete. Just look at Vivus (VVUS)
VVUS, +7.37%
, the maker of the Muse impotency product. The development of Pfizer's (PFE)
PFE, -1.65%
Viagra pill sent shares of Vivus skidding into the low single-digits, down from a high of 40-plus in 1997.

Plus, "technology often proved to be more difficult to commercialize than it first appeared to be," pointed out Medical Technology Stock Letter editor Jim McCamant.

Changing or unproven technologies should also be a big concern for Internet investors. Take the market for cable-based Internet access. At Home's (ATHM)
ATHM, -4.93%
subscriber growth has fallen well short of the company's initial pre-IPO forecasts.

And if companies like At Home do end up being wildly successful, how will they alter the industry? Will "dial-up" ISPs still have a market? Will Yahoo (YHOO)
yhoo
have to partner with TCI? And will cable operators appreciate companies like Broadcast.com (BCST)
bcst
distributing streaming video of TV-like quality?

Patience is a virtue

In the end, however, impatience was the biggest needle in the bursting of the biotech bubble. Investors got sick of promises and demanded immediate results, which just wasn't possible for many of the drug developers.

"I made a lot of money in biotechs, but I did sometimes have difficulty understanding how the model was going to work," Colella said. "What ended the parade was that very few of these companies produced on the bottom line."

A similar impatience could crush Internet companies, many of whom are spending aggressively to build a brand and market share at the expense of the bottom line (E-Trade (EGRP)
EGRP, -0.18%
and Amazon, for instance, have seen their stocks blossom after announcing that profits would be delayed).

If investors all of a sudden decided Internet stocks weren't worth multiples to sales in the hundreds, a lot of Web players would have to change their strategies drastically.

"I'm not saying the development of the Internet is going to take as long as drug development, but I think it's going to take a lot longer to build up the profits that these valuations are justifying," Leathers said.

Post-bubble aftershocks

Investors should also note what's happened to the biotech sector post-bubble. The industry is dominated by giant companies, such as Genentech and Amgen (AMGN)
AMGN, -1.57%
, while the vast majority of companies toil along in microcap land. In 1998, the 10 largest biotech stocks, which make up more than half of the market cap in the industry, returned 70 percent, while those not in the top 200 lost 47 percent for the year.

Many analysts feel the same thing could happen with the Internet. The Internet is destined to be huge, perhaps the most important technological development in history, but there will be plenty of losers.

"They don't all win. They don't all make it," said Evergreen's Sonderling. "For every success, there's bound to be multiple failures."

And despite the widely-held belief in first-mover advantages, the early entrants may not be the eventual winners.

By utilizing their substantial market power and financial resources, traditional pharmaceuticals like Merck and Pfizer have stolen a lot of the thunder from the biotechs, Biokeys' Gray noted. The Internet sector could experience the same phenomenon when companies like Wal-Mart or Tower Records decide to get serious about the Web.

If a shakeout were to occur, the red-hot Internet IPO market would surely take a hit. In biotech, the number of initial offerings fell to 12 in 1998 from 22 in 1997, with proceeds falling to $417 million from $750 million.

"When the [biotech] collapse came, they had trouble raising capital even for legitimate, well-focused ventures," said Albert Greene, president of Healthcentral.com.

Back to the drugstore

Of course, drugstore.com shouldn't have any problem going public. Although the company hasn't yet opened its store, many observers have already anointed it as the sequel to Amazon.com.

Conference attendees hoping to get the inside scoop on drugstore.com were likely disappointed as Chief Executive Peter Neupert certainly came through on his pre-presentation promise to disclose little of the company's strategy "for competitive reasons." (Rival PlanetRx also gave a presentation at the conference).

Not that Uri Reiner, a biotech analyst with Chicago-based Kilkenny Capital Management, would have been able to hear if Neupert had said anything anyway. Reiner, one of the people that had to stand outside the conference room because of the crowd, said he doesn't know what to think of all this Net madness or how it relates to the biotech bubble of the past.

"I don't know much about the Internet, except that I wish I owned some stocks," he said.

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